March 11, 2009

Another side of the administration’s tax plan

While discussions of the Obama administration's tax plan focus on the expected impact on consumer spending and the federal deficit, not much attention has been given to the incentives of the plan for work effort. Different tax rates, deductions, and rebates provide varying degrees of incentives to work less or work more, and those incentives differ across income groups. Here I want to focus on just one of the proposed changes: the reinstatement of the 39.6 percent marginal tax rate for the wealthy.

Supply side economists tout low tax rates across the board as a way to provide incentives for people to work harder and thus for the economy to grow faster; with this thinking, people work harder because they get to keep more of the money they're working for.

Results in a recent working paper, with coauthor Robert Moore, confirm these predictions by finding that work effort increased across all income levels when tax rates were cut (among other things) in the 2001 Bush administration tax reform. But work effort increased much less among the more educated (higher income) families.

The administration's current budget plan includes a reversion of the marginal tax rate among the wealthiest to the pre-Bush tax rates—an increase from 35 to 39.6 percent. This tax rate increase is equivalent to reducing a worker's wage by 7 percent. The chart shows what the impact on work effort would be across education/income groups if wages were decreased for both groups by 7 percent; education and income are very highly correlated. The analysis found that husbands with a high school degree only would reduce their hours worked by about 63 hours per year (about 2.9 percent), whereas husbands with a college degree or more would reduce their work hours by only 42 hours per year (about 1.8 percent). Working wives in these families would also reduce their hours of work.

So, based on my research, if a need to raise some revenue means tax rates have to be increased for someone, raising them on the wealthiest will result in a smaller reduction in work effort than raising tax rates on the middle class.

The calculations here use results obtained from estimating a joint labor supply model for dual-earner families with different levels of education for the year 2000. A complete analysis of the work effort implications from the administration's tax plan would require accounting for all the changes to marginal tax rates, phase-outs of deductions, and tax credits simultaneously, as well as considering the impact on decisions of family members to enter or exit the labor market in response to the tax changes.

An additional relevant question remains: What is the implication of changing work effort for GDP growth? The relationship between work effort and value of output is not necessarily the same across income levels. In other words, one hour of high-income (higher education) labor is expected to yield a higher value of output in the economy than one hour of labor from a middle-income (lower education) worker. A complete analysis of the aggregate impact of the administration's tax plan would have to also take this into account.

By Julie Hotchkiss, research economist and policy adviser at the Atlanta Fed

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"an increase from 35 to 39.6 percent. This tax rate increase is equivalent to reducing a worker's wage by 7 percent."

This is misleading. The increase is an increase in marginal rates only: only on the income above a set level. Therefore moving from 35% to 39.6% marginal tax rate is NOT like a 7% reduction in worker's wage. It is only a reduction of 7% in the marginal wage. Statements like this that say "it's equivalent to a reduced wage of 7%" obfuscate the debate.

Further, workers' incentives are no doubt in response to marginal total taxation, not just marginal Fed Income tax. The brackets for which margina Fed income tax is actually increasing from 35-39.6% are those brackets that pay a lower marginal tax (0%) on SS/Medicare taxes, while lower income brackets face a steep additional approx 7% marginal tax on top of marginal fed income tax rates.

But why is there no mention of the income and substitution effects, and the backward bending labor supply curve? As income gets higher, at some point the income effect outweighs the substitution effect, and the resulting labor supply curve bends back, implying that people at that income level and above would work more when their taxes are raised because of the strong income effect, because they have to to maintain their current lifestyle. Last I checked, research implied that the backward bend began at about the upper middle class level.

And, of course, sadly, the pink elephant of economics, positional/context/prestige externalities (see Cornell Economist Robert Frank's article: http://www.robert-h-frank.com/PDFs/WP.1.24.99.pdf) is almost never mentioned. Cut taxes on the very wealthy and the spending is overwhelmingly on zero sum game positional/context/prestige externality goods that add very little total utils to society, especially relative to the basically non-positional things that money could have been spent on like basic medical and scientific research, alternative energy, education, public health and safety, etc.

For an excellent brief article on the income and substitution effects and the backward bending labor supply curve, and the historically weak relationship between income, taxes, and hours worked, see Cornell Economist Robert Frank's article:

In fact, I think we can speculate on some of the positional/prestige/context spending that occurred in the upper income brackets in the past 8 years as the marginal rates were lowered to 35%. Actually the rate for some has been 16% since for many of these people they were were given a loophole that let them claim that being paid to manage a fund (labor) was actually capital gains (investment of capital) when they had nothing at risk.

What did high income folks do with their lower-marginal tax rate enhanced take-home pay? It appears that more than a few bought second homes (and third homes and more). They bought real estate assets. They "invested" the money, but unlike in past cycles the investments were in hedge funds and derivatives. Financial devices that added relatively little to the real stock of capital goods and productive capability in the economy. As for the additional homes, I don't think that's worked out too well for us, has it?

Your analysis is in a vacuum. What if the hours that the wealthy work are more productive than the hours the middle class work?

The other issue in the Obama tax plan is the increase in not only marginal tax rates, but increases in FICA tax rates, reductions in the ability to deduct to charities and mortgages, and the other increases in the federal bureaucracy that will explode entitlement spending.

I have hearsay anecdotes that say that if you collect welfare under the Obama plan it is more than working 8 hours a day for a minimum wage job. This will certainly also decrease production.

Obama would do well to leave the current brackets and marginal rates as they are, and instead add new brackets and higher marginal rates on top of that structure. There is no reason for a progressive income tax system to stop being progressive at $357k of income. He could easily add a 39.6% bracket at 500K or so and a second, even higher bracket at 1M or 2M. Furthermore, why not make the rates on dividends and capital gains progressive?

I took a look at your paper. As is common, there are potential problems with the model and paper. It only looks at 2001 changes in taxes; how would it do out of sample. The groupings are course, and there are other issues I won't get into now. But I would like to note that the other research appears to go against your implication (at least many could interpret it this way) that these tax cuts would induce a widespread increase in hours worked.

This is from a survey of the labor supply elasticity literature by Harvard Labor Economist George Borjas, from his 2008 text, "Labor Economics", 4th ed.

Few topics in applied economics have been as thoroughly researched as the empirical relationship between hours of work and wages (pg. 45)...The neoclassical model of labor-leisure choice implies that the sign of the coefficient beta depends on whether income or substitution effects dominate (pg.s 45-6)...There are almost as many estimates of labor supply elasticity as there are empirical studies in the literature. As a result, the variation in the estimates is enormous. Some studies report the elasticity to be zero; other studies report it to be large and negative; still others report it to be large and positive. There have been some attempts to determine which studies are most credible. These surveys conclude that the elasticity of male labor supply is roughly around -0.1. In other words a 10% increase in the wage leads to a 1% decrease in hours of work for men. The dominance of income effects is often used to explain the decline in hours of work between 1900 and 2000 (pg. 46, emphasis added)...Labor supply elasticities in the United States are small: Hours of work do not respond much to wage changes. Moreover income effects tend to dominate (at least for working men). The available evidence, therefore, does not support the argument that income tax cuts could increase tax revenues in the United States. (pg. 51)

As a comment on the paper, I was a little bothered by the mention of the dual income model and then a sentence or two about low-income families but nothing clearly stated about the numbers of dual income families at the various economic levels, nor what was done with single parent families, etc. Taking the work at its face, I found the data source fairly weak and the implications then weakened by the paucity of discussion (lack of data?) about exactly which actual group in numbers in society might fit this model.

I would also like to agree generally with the first comment above. A better statement is there would be a 4.96% increase in the marginal tax on income above $x - which I believe is something like $370k for a joint return.

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